What, then, was the proper government policy during the 1920s? What should government have done to prevent the crash? Its best policy would have been to liquidate the Federal Reserve System, and to erect a 100 percent gold reserve money; failing that, it should have liquidated the FRS and left private banks unregulated, but subject to prompt, rigorous bankruptcy upon failure to redeem their notes and deposits

https://mises.org/library/how-business-cycle-happens

Murray N. Rothbard

Study of business cycles must be based upon a satisfactory cycle theory. Gazing at sheaves of statistics without “pre-judgment” is futile. A cycle takes place in the economic world, and therefore a usable cycle theory must be integrated with general economic theory. And yet, remarkably, such integration, even attempted integration, is the exception, not the rule. Economics, in the last two decades, has fissured badly into a host of airtight compartments—each sphere hardly related to the others. Only in the theories of Schumpeter and Mises has cycle theory been integrated into general economics.1

The bulk of cycle specialists, who spurn any systematic integration as impossibly deductive and overly simplified, are thereby (wittingly or unwittingly) rejecting economics itself. For if one may forge a theory of the cycle with little or no relation to general economics, then general economics must be incorrect, failing as it does to account for such a vital economic phenomenon. For institutionalists—the pure data collectors—if not for others, this is a welcome conclusion. Even institutionalists, however, must use theory sometimes, in analysis and recommendation; in fact, they end by using a concoction of ad hoc hunches, insights, etc., plucked unsystematically from various theoretical gardens. Few, if any, economists have realized that the Mises theory of the trade cycle is not just another theory: that, in fact, it meshes closely with a general theory of the economic system.2 The Mises theory is, in fact, the economic analysis of the necessary consequences of intervention in the free market by bank credit expansion. Followers of the Misesian theory have often displayed excessive modesty in pressing its claims; they have widely protested that the theory is “only one of many possible explanations of business cycles,” and that each cycle may fit a different causal theory. In this, as in so many other realms, eclecticism is misplaced. Since the Mises theory is the only one that stems from a general economic theory, it is the only one that can provide a correct explanation. Unless we are prepared to abandon general theory, we must reject all proposed explanations that do not mesh with general economics.

Business Cycles and Business Fluctuations

It is important, first, to distinguish between business cycles and ordinary business fluctuations. We live necessarily in a society of continual and unending change, change that can never be precisely charted in advance. People try to forecast and anticipate changes as best they can, but such forecasting can never be reduced to an exact science. Entrepreneurs are in the business of forecasting changes on the market, both for conditions of demand and of supply. The more successful ones make profits pari passus with their accuracy of judgment, while the unsuccessful forecasters fall by the wayside. As a result, the successful entrepreneurs on the free market will be the ones most adept at anticipating future business conditions. Yet, the forecasting can never be perfect, and entrepreneurs will continue to differ in the success of their judgments. If this were not so, no profits or losses would ever be made in business.

Changes, then, take place continually in all spheres of the economy. Consumer tastes shift; time preferences and consequent proportions of investment and consumption change; the labor force changes in quantity, quality, and location; natural resources are discovered and others are used up; technological changes alter production possibilities; vagaries of climate alter crops, etc. All these changes are typical features of any economic system. In fact, we could not truly conceive of a changeless society, in which everyone did exactly the same things day after day, and no economic data ever changed. And even if we could conceive of such a society, it is doubtful whether many people would wish to bring it about.

It is, therefore, absurd to expect every business activity to be “stabilized” as if these changes were not taking place. To stabilize and “iron out” these fluctuations would, in effect, eradicate any rational productive activity. To take a simple, hypothetical case, suppose that a community is visited every seven years by the seven-year locust. Every seven years, therefore, many people launch preparations to deal with the locusts: produce anti-locust equipment, hire trained locust specialists, etc. Obviously, every seven years there is a “boom” in the locust-fighting industry, which, happily, is “depressed” the other six years. Would it help or harm matters if everyone decided to “stabilize” the locust-fighting industry by insisting on producing the machinery evenly every year, only to have it rust and become obsolete? Must people be forced to build machines before they want them; or to hire people before they are needed; or, conversely, to delay building machines they want—all in the name of “stabilization”? If people desire more autos and fewer houses than formerly, should they be forced to keep buying houses and be prevented from buying the autos, all for the sake of stabilization? As Dr. F.A. Harper has stated:

This sort of business fluctuation runs all through our daily lives. There is a violent fluctuation, for instance, in the harvest of strawberries at different times during the year. Should we grow enough strawberries in greenhouses so as to stabilize that part of our economy throughout the year.3

We may, therefore, expect specific business fluctuations all the time. There is no need for any special “cycle theory” to account for them. They are simply the results of changes in economic data and are fully explained by economic theory. Many economists, however, attribute general business depression to “weaknesses” caused by a “depression in building” or a “farm depression.” But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression—a phenomenon of the true “business cycle.” Suppose, for example, that a shift in consumer tastes, and technologies, causes a shift in demand from farm products to other goods. It is pointless to say, as many people do, that a farm depression will ignite a general depression, because farmers will buy less goods, the people in industries selling to farmers will buy less, etc. This ignores the fact that people producing the other goods now favored by consumers will prosper; their demands will increase.

The problem of the business cycle is one of general boom and depression; it is not a problem of exploring specific industries and wondering what factors make each one of them relatively prosperous or depressed. Some economists—such as Warren and Pearson or Dewey and Dakin—have believed that there are no such things as general business fluctuations—that general movements are but the results of different cycles that take place, at different specific time-lengths, in the various economic activities. To the extent that such varying cycles (such as the 20-year “building cycle” or the seven-year locust cycle) may exist, however, they are irrelevant to a study of business cycles in general or to business depressions in particular. What we are trying to explain are general booms and busts in business.

In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange—money. Money forges the connecting link between all economic activities. If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if all prices move up or down together, some change must have occurred in the monetary sphere. Only changes in the demand for, and/or the supply of, money will cause general price changes. An increase in the supply of money, the demand for money remaining the same, will cause a fall in the purchasing power of each dollar, i.e., a general rise in prices; conversely, a drop in the money supply will cause a general decline in prices. On the other hand, an increase in the general demand for money, the supply remaining given, will bring about a rise in the purchasing power of the dollar (a general fall in prices); while a fall in demand will lead to a general rise in prices. Changes in prices in general, then, are determined by changes in the supply of and demand for money. The supply of money consists of the stock of money existing in the society. The demand for money is, in the final analysis, the willingness of people to hold cash balances, and this can be expressed as eagerness to acquire money in exchange, and as eagerness to retain money in cash balance. The supply of goods in the economy is one component in the social demand for money; an increased supply of goods will, other things being equal, increase the demand for money and therefore tend to lower prices. Demand for money will tend to be lower when the purchasing power of the money-unit is higher, for then each dollar is more effective in cash balance. Conversely, a lower purchasing power (higher prices) means that each dollar is less effective, and more dollars will be needed to carry on the same work.

The purchasing power of the dollar, then, will remain constant when the stock of, and demand for, money are in equilibrium with each other: i.e., when people are willing to hold in their cash balances the exact amount of money in existence. If the demand for money exceeds the stock, the purchasing power of money will rise until the demand is no longer excessive and the market is cleared; conversely, a demand lower than supply will lower the purchasing power of the dollar, i.e., raise prices.

Yet, fluctuations in general business, in the “money relation,” do not by themselves provide the clue to the mysterious business cycle. It is true that any cycle in general business must be transmitted through this money relation: the relation between the stock of, and the demand for, money. But these changes in themselves explain little. If the money supply increases or demand falls, for example, prices will rise; but why should this generate a “business cycle”? Specifically, why should it bring about a depression? The early business cycle theorists were correct in focusing their attention on the crisis and depression: for these are the phases that puzzle and shock economists and laymen alike, and these are the phases that most need to be explained.

The Problem: The Cluster of Error

The explanation of depressions, then, will not be found by referring to specific or even general business fluctuations per se. The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors? This is the first question for any cycle theory. Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting.

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